Commentary: Return on Investment: Climate Risk and Green Bonds

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This article was published in The Economist Intelligence Unit on September 1, 2016. 

Caio Koch-Weser is a member of the Global Commission on the Economy and Climate, Vice Chairman of Deutsche Bank Group, and Chair of the Board of the European Climate Foundation.

The Paris Climate Change Agreement was received enthusiastically by the majority of people across the world. While the terms of the Agreement appeared sound, people also wondered what it meant for them, and how they could help make the details a reality.

The truth is that the low-carbon transition is hugely important, not just in the obvious sense of preventing the worst effects of climate change, but also for individuals, not least in the way they save and invest. If we are to deliver on last year’s historic accord, finance – especially private finance – will be critical to the low-carbon transition. This involves us all not just as citizens, but as individual investors.

Huge transitions create huge opportunities and risks. Climate mitigation policies create opportunities for investment in low-carbon technologies, products and processes, but they also render many fossil fuel and related assets uneconomical. Delaying action increases the likeliness of a disorderly economic transition with significant costs. For finance to play its proper role, investors large and small need to grapple with the opportunities in low-carbon investment, as well as the risks and challenges of being stuck in the old, high-carbon economy.

Green finance is however gaining prominence. In December 2015, more than 400 investors with US$24 trillion in assets made a commitment through the Investor Platform for Climate Actions to increase low-carbon and climate-resilient investments.

Looking at the green bond market provides us with a good illustration of this. In Europe US$18.4bn green bonds were issued in 2014. Seven new countries jumped on the bandwagon: Brazil, Denmark, Estonia, Hong Kong, India, Latvia, and Mexico. Issuances of green bonds reached US$42 billion, a record high in 2015. This year, Apple issued US$1.5 billion in green bonds, generating headlines as the largest so far by a US company. The People’s Bank of China established a green bond market that opened to strong private interest in January. China’s total green bond market is expected to rapidly grow to an astonishing US$230 billion in the next five years.

Green bonds are exactly the same as other bonds, except that they are directed to raise money for green investments, which are often targeted specifically to renewable energy and energy efficiency projects. A much smaller percentage of green bonds help to finance other types of low-carbon or environmental projects – such as transport, water, and waste – and there is much room for expansion.

Green bonds can be an effective tool to raise finance for the low-carbon economy. However, while issuers can voluntarily certify their bonds through the Green Bond Principles, one of the biggest challenges so far is that there is no globally accepted definition of what counts as “green.” Clear, transparent standards could guard against greenwashing, make it much easier for investors to recognise the credibility of such bonds in the marketplace, and ensure that the underlying projects do indeed result in investments that place economic growth on a pathway to keep global temperature rise well below 2°C.

A handful of green bond indices have been launched in recent years, bringing together all those bonds that have been certified through the Green Bonds Principles or other methods. These aggregations allow investors to more easily purchase baskets of green bonds. For example, the Barclays-MSCI Green Bond Index was launched in November 2014. Its eligibility criteria include – and exceed – the Green Bond Principles. S&P has two green bond indices as well.

It is pleasing to see the finance world increasingly grasping the opportunity side of the low-carbon transition but what about the risks? Any prudent investor looks not only at the opportunities in their portfolio, but also the risks, especially of legacy investments. Green finance and climate risk are two sides of the same coin. While green finance is by definition directed to low-carbon investment, climate risk results from increasing commitment to keeping global temperature rise well below 2°C.

As regulation tightens to mitigate climate change, high-carbon assets will likely increasingly lose value. Therefore, the higher the carbon intensity of an asset or portfolio, the more investors, owners and managers must measure, model and address the risks they face. In May 2016, investors with more than US$10 trillion in assets endorsed shareholder resolutions calling on ExxonMobil and Chevron to stress-test their business strategies against a scenario in which climate actions were taken to keep global warming below 2°C; despite the fact that both measures failed, each was backed by about two-fifths of shareholders.

Just as with green finance, common definitions and standards of transparency for climate risk are key to increase the confidence and efficiency of markets, and thus economic stability. A number of countries are leading the way. France, for example, has introduced mandatory corporate disclosure of climate information. The Chinese central bank has proposed mandatory climate disclosure as part of a series of other reforms to help green its banking system.

An industry-led task force, established under the Financial Stability Board (FSB) at the request of G20 Finance Ministers, is drafting recommendations for measures to disclose climate-related financial risks. Convened by the Bank of England Governor, Mark Carney and chaired by Michael Bloomberg, a US business magnate, politician, and philanthropist, the Task Force on Climate-related Financial Disclosures involves, among others, AXA Group, JPMorgan Chase & Co., UBS Asset Management, Unilever, and Daimler. The imprimatur of the FSB, and the personal commitment of many private sector experts provides a unique opportunity to create a roadmap for getting climate risk disclosure right, and over time creating one clear framework and standard for all.

Clear definitions of what counts as green on the one hand, and transparency requirements concerning carbon risk on the other hand would allow informed investment decisions and help ensure an efficient and smooth low-carbon transition.

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